In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss the origin of the Federal Reserve’s 2% inflation rate target and explain how the Fed influences the economy to achieve its dual mandate of maximum employment and price stability.
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“And to bring it back to housing like we always do, the federal funds rate doesn't directly impact mortgage rates. But quantitative easing is a direct intervention in the mortgage market, purchasing mortgage-backed securities directly puts downward pressure on mortgage rates and buying longer, particularly 10-year treasury bonds, also has a big impact on mortgage rates, because we all know how those two are connected. This is how we got so low with mortgage rates a little over a year ago.” – Odeta Kushi, deputy chief economist at First American
Odeta Kushi - Hello, and welcome to episode 57 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark, have you ever heard the metaphor regarding the Fed and punch bowls?
Mark Fleming - Hi, Odeta. Of course I have. It's perhaps the most frequently cited metaphor for the Federal Reserve's role in managing the economy. But I wonder where did this metaphor come from?
Odeta Kushi - Well, I'm so glad you asked. In October 1955, Fed Chair William McChesney Martin Jr. delivered a speech to the New York group of the Investment Bankers Association of America. He said, quote, The Federal Reserve is in the position of the chaperone who has ordered the punch bowl removed, just when the party was really warming up, end quote.
Mark Fleming - So, like an economic spoilsport of sorts, I suppose. But what I find more interesting about that quote is that he says the Fed has to be the chaperone. In other words, to accompany and supervise, but not necessarily participate in the economy.
Odeta Kushi - And that supervision of the party goers comes in the form of a dual mandate. In today's episode, we'll talk a little bit about that and the mechanics of the federal funds rate. Let's begin with the dual mandate, which are maximum employment and price stability. The inflation target is at the rate of 2%, as measured by the annual change in the price index for personal consumption expenditures, or PCE. But when and how did that come from anyway, that 2% target?
Mark Fleming - I just have to say we're doing a whole episode on the inner workings of the Fed. Buckle up listeners, it'll be fun. It'll be fun. Okay, first, let's guess the when on that 2% target, you would think it was determined long, long ago in a galaxy far, far away?
Odeta Kushi - I mean it seems that way, right? We've been talking about 2%, forever.
Mark Fleming - You would think so. But, believe it or not, the Federal Open Market Committee, or FOMC, hadn't explicitly named an inflation target until...are you ready for this? 2012. Yep. Just barely a decade ago, which is when then Chairman Ben Bernanke made the 2% target explicit.
Odeta Kushi - 2012? I was still in college in 2012. Alright, so there's got to be some kind of theoretical or empirical evidence to support this 2% target, right?
Mark Fleming - Again, yes, of course, you would think so, right? We're economists, we love our economic theory. But when it comes to inflation, it's the Goldilocks principle -- 2% is sort of not too hot, not too cold. And listeners, there is indeed a Wikipedia page, definitive source, of course, dedicated to this Goldilocks principle, although I really don't recall learning about it in any of my economics courses in school.
Odeta Kushi - Well, maybe that's because you were using Wikipedia as your source.
Mark Fleming - It was barely invented when I was in school.
Odeta Kushi - Oh goodness. Well, that begs the question, why is the Fed's target a positive number? Why can't the inflation goal be 0% or no inflation?
Mark Fleming - I'm so glad you asked, Odeta. David Wheelock, a St. Louis Fed group vice president and deputy director of research addressed these questions in a 2017 podcast where he laid out three reasons. Number one, measuring inflation precisely is difficult. Ha, you don't say after recent events. And the index has a slight upward bias. So, when we have inflation of 1-2%, it may be actually closer to zero. Secondly, if you believe that interest rates and inflation are proportional, as some do, then a higher than zero inflation target gives you some room to cut interest rates if you need to. And third, to me, Mark Fleming, the most intuitive explanation is because the fear of deflation is just too great.
Odeta Kushi - The dreaded deflation. This is the exact opposite of inflation. It's when prices fall, and it's scary because it can really depress an economy. When people feel that prices are going to keep falling they delay big purchases in hopes that they can just buy the item for less in the future.
Mark Fleming - Why buy today when you can buy for less in the proverbial tomorrow. Lower spending, lower income from businesses and producers. That leads to lower GDP and higher unemployment. Higher unemployment can result in even lower prices, less spending. We've talked about inflationary spirals in the past, but this is a deflationary spiral, which is also concerning, if not just plain scary.
Odeta Kushi - Alright, so there is some reasoning behind this 2% target.
Mark Fleming - It's, uh, just right, at least for now.
Odeta Kushi - And just to clarify, Fed officials have often explained that the 2% target is not necessarily a short-term target, but rather that monetary policy should be set so that inflation moves towards the target over time. So it's okay to over- and under-shoot the target at any point in time. But, in the long-run average, we should reach that 2% target.
Mark Fleming - So, I guess, right now, we're working on the over-shoot side of things. Hopefully trying to get back down to the target, when we were for a long time actually undershooting. But now let's get to the other mandate, which is full employment. How is that determined?
Odeta Kushi - So, typically, the benchmark for full employment is the natural rate of unemployment. Or you can take a look at the FOMC summary of economic projections, also known as SEP, which outlines a longer run normal rate of unemployment. The latest December projections have that in the range of 3.5% to 4.8%, with a median of about 4%.
Mark Fleming - So, given the unemployment rate as of the latest December jobs report at 3.5%, I think the Fed is doing pretty well with that mandate.
Odeta Kushi - Well, that's one of the reasons that they've been able to fight inflation so aggressively with their monetary tightening, the labor market has remained pretty resilient.
Mark Fleming - You don't have to worry about one or you can only worry about the other. The irony, of course, being that now the Fed wants the labor market, and specifically wage growth, to slow in essence to avoid the dreaded wage-price inflation spiral.
Odeta Kushi - Yes, but we digress. Back to the mandates. How does the Fed conduct monetary policy?
Mark Fleming - Okay, here we go. Two primary levers that the Fed can pull. I'm just envisioning the Wizard of Oz -- pay no attention to the man behind the curtain. Okay, okay. First and foremost, adjusting the federal funds rate. We've all heard about this. And secondly, quantitative easing.
Odeta Kushi - So, let's just go through the mechanics of these levers, because oftentimes, I find that, let's say, while making conversation at a dinner party, someone will mention that the Fed increased rates. But, when I ask, well, do you know how they do that? They usually don't.
Mark Fleming - Alright, you might need to get out a little more. Because why are you grilling people about the Fed at dinner parties and do you even get invited back?
Odeta Kushi - So, is that not standard conversation?
Mark Fleming - No, I think we can all agree that it's not standard conversation. But, we digress again, to Odeta's dinner party preferences. Let's tackle that fed funds rate first. A quick definition -- the federal funds rate is the interest rate used for overnight interbank lending in the United States. Your turn.
Odeta Kushi - And that rate is adjusted to conduct monetary policy. Well, I know when I first learned about how the FOMC conducts its policies, I learned that it sets a desired target range for the federal funds rate and then influences the supply of money and credit through daily open market operations. In other words, the Fed buys or sells U.S. government securities, which influences the level of reserves in the banking system. Another little definition here -- reserves are the cash that banks hold, plus deposits that they maintain, at Federal Reserve Banks. And reserves matter because when a bank needs additional reserves in the short term, it can borrow from other banks that have more reserves than they need. The federal funds rate is the interest rate on the overnight borrowing of reserves in this interbank lending. If demand for reserves is higher than the supply, the federal funds rate increases and vice versa.
Mark Fleming - Yes, and quote, daily open market operations, is what the Fed used in the past to influence the federal funds rate prior to the Great Financial Crisis. But times have changed. Now, daily open market operations are used to simply ensure that there is enough cash reserves floating around in the banking system sufficient for all the banks lending to each other every night. But I still think it's worth explaining.
Odeta Kushi - Right. So that's how the Fed used to influence the federal funds rate.
Mark Fleming - That's right, let's break that down. If the Fed wants the federal funds rate to decrease, then it buys government securities from the banks. As a result, those banks end up holding fewer securities and more cash because the Fed gives them cash in exchange for those securities, which they then lend out in the federal funds market to other banks. Basically, you've added cash supply. That increases the supply of available reserves in the system, and causes the federal funds rate to decrease. Like, I'll charge you less to borrow from me if I have more to lend.
Odeta Kushi - And the opposite is also true. When the Fed wants to increase the federal funds rate, it does the reverse open market operation of selling government securities to the banks. That decreases the supply of reserve balances in the banking system.
Mark Fleming - The Fed could also decrease or increase the discount rate or reserve requirements to influence bank lending, but we won't go into too much detail there.
Odeta Kushi - Alright, so what we just explained was the old school way of influencing the Fed funds rate, but the Fed now has a new framework called ample reserves, and it differs from what we just described because it's a way for the Fed to set the rate, instead of let the market determine it. The primary tool is called interest on reserves or IOR. Care to elaborate, Mark?
Mark Fleming - Yes, my turn. Well, we mentioned that banks sometimes use cash to lend to other banks. But that's not the only way that banks can earn interest on the cash reserves that they have. They can also deposit it into their reserve account at the Fed. The Fed is like the bankers' bank, right. And they earn interest on those reserves and the Fed sets the IOR as the interest rate that you would earn on your reserves held at the bankers' bank.
Odeta Kushi - So, basically, this IOR is like the risk-free option, and the federal funds rate should not fall below the IOR rate.
Mark Fleming - Yes, risk free in the sense that we all believe that the Fed will always be able to give me my cash back if I asked for it. Because if the fed funds rate was below the IOR rate, then banks could borrow at the federal funds rate from each other, deposit it in the reserves at the Fed for a higher IOR and a profit. That doesn't happen.
Odeta Kushi - Ah, an arbitrage opportunity, right. Let's pivot to the other way that the Fed has influenced the economy and even the housing market. Quantitative Easing.
Mark Fleming - Yes, our favorite, relatively new tool. In fact, after the 2008 crisis, the Fed lowered the fed funds rate to zero. But where else would you go from there? So, in addition, and for the first time ever, they started purchasing U.S. Treasury bonds and mortgage-backed securities or MBS. Participating in the bond market directly like this was a first and otherwise known as quantitative easing or tightening depending upon whether one is buying or selling bonds in the market.
Odeta Kushi - And to bring it back to housing like we always do, the federal funds rate doesn't directly impact mortgage rates. But quantitative easing is a direct intervention in the mortgage market, purchasing mortgage-backed securities directly puts downward pressure on mortgage rates and buying longer, particularly 10-year treasury bonds, also has a big impact on mortgage rates, because we all know how those two are connected. This is how we got so low with mortgage rates a little over a year ago. This is a definition-heavy episode. By the way, a lot of definitions and further explanations of these concepts are linked in the transcript on our website at firstam.com/economics. So, quantitative easing, also known as QE, is when the central bank buys billions of dollars in assets, mostly U.S. Treasury securities, federal agency debt and mortgage-backed securities or MBS to increase the supply of money and bring down rates. The opposite of that would be selling mortgage-backed securities, which would put upward pressure on rates. The Fed isn't doing this just yet, but it has stopped buying MBS. This process of unwinding the balance sheet, or purchasing fewer securities, is the Fed's attempt to prevent the economy from overheating.
Mark Fleming - Right, the Fed has a few options when it comes to this reduction of balance sheet -- reinvestment, run off and, ultimately, selling. The Fed can reinvest all or some of the proceeds from maturing securities to reduce the balance sheet gradually. It can also allow the portfolio to run off, which means not reinvesting any of the proceeds from the maturing securities. Basically, putting that cash back into the Fed's account and taking it out of the economy. And, finally, it could actually sell the securities.
Odeta Kushi - That's probably the fastest way, right, is selling?
Mark Fleming - Exactly, selling is the fastest.
Odeta Kushi - Okay, so mechanically, reducing the balance sheet or quantitative tightening could mean that when a treasury security hits its maturity date, the Fed doesn't reinvest the proceeds into another treasury security, but rather redeems the security.
Mark Fleming - That's right. And, as you said, selling is the fastest way to quantitatively tighten, but you get quantitative tightening by simply doing this reinvestment, rather than redeeming the security. That reduces the size of the balance sheet and doesn't put the cash back into the economy. And so, voila, you have upward pressure on longer term rates and mortgages.
Odeta Kushi - All right. Well, I think we've had enough Fed talk for now. I'm sure we'll get back to it later, but I think that's enough for one episode.
Mark Fleming - It'll be all the rage for at least the first half of this year. Maybe you could just send this podcast to the guests at your next dinner party, Odeta? A little pre-party hors d'oeuvre might be, just right. Get it? See what I did there.
Odeta Kushi - Absolutely. Yeah, I sure did. Well, I don't think I'll be invited to many more dinner parties after that. But, you know, maybe I'll give it a go. All right. Well, that's it for today. Thank you for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And, as always, if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.
This transcript has been edited for clarity.